MACROECONOMICS

5th - 7th Lecture

Income in a Closed and Open Economy (Long run Case)

Instructor: Tamali Chakraborty

What is closed economy?
 Closed Economy vs Open Economy
In a closed economy, a country’s spending at any given year
is equal to its output of goods and services.

In an open economy, a country’s spending at any given year

is not needed to be equal to its output of goods and services.
The country can spend more than it produces by borrowing
from abroad, or it can spend less than it produces and lend the
difference to foreigners.
Outline of Closed Economy Model
A closed
economy, market-
clearing model

Supply side Demand side Equilibrium

factor markets
determinants of
(supply, demand, goods market
C, I, and G
price)

determination of loanable funds

output/income market
Circular Flow re-visited

Source: Chapter 3, Macroeconomics 9th Ed, N.G. Mankiw

 The Components Of GDP

6 (Y) is the sum of the following:

• GDP
• Consumption (C)
• Investment (I)
• Government Purchases (G)
• Net Exports (NX)

Y = C + I + G+ NX is a macroeconomic identity.
 Expenditure Approach

GDP –Expenditure Method

Domestic Private
Consumption C Government G Net Exports NX*
Investment I

Kalyan K
Fixed Investment
Non-
Durables Defence Spend Exports EX(+)
Residential(Firms)
Residential(HH)

∆ Private Non-Defence
Non-Durables Imports IM(-)
Inventory Spend

Services Investment

* The economy when “closed” has NX=0

• Modelling an CLOSED Economy in the long-run
What is long run in Macroeconomics?
• Y = F(K, L)
The
• shows how much output (Y ) the economy can produce from
K units of capital and L units of labor
production
• the economy’s level of technology
function
reflects
• exhibits constant returns to scale
 Assumptions of an economy in the long-run

1. Technology is fixed.
2. The economy’s supplies of capital and labor are fixed at

K =K and L=L
 Fixed (Potential) GDP in long-run
Output is determined by the fixed factor supplies and the fixed state of
technology:

Y = F (K , L)

Potential Output is fixed in the long-run as long as K and L are fixed.

 Outline of model
• A closed economy, market-clearing model
• Supply side
❑ factor markets (supply, demand, price)
❑ determination of output/income

• Demand side
❑ determinants of C, I, and G

• Equilibrium
❑ goods market
❑ loanable funds market
 Demand for goods & services

Components of aggregate demand:

C = consumer demand for g & s
I = demand for investment goods
G = government demand for g & s
(closed economy: no NX )
 Consumption ( C )

• Def: Disposable income is total income minus total taxes: Y – T.

• Consumption function: C = C (Y – T )
Shows that (Y – T )  C
• Def: Marginal propensity to consume (MPC) is the increase in C
caused by a one-unit increase in disposable income.
 The consumption function
C

C (Y -T)

The slope of the

MPC
consumption
1 function is the MPC.

Y–T
 Investment (I)

• The investment function is I = I(r),

• where r denotes the real interest rate,
the nominal interest rate corrected for inflation.

• The real interest rate is

• the cost of borrowing
• the opportunity cost of using one’s own funds to finance investment spending.

• So, r  I
 The investment function

r
Spending on
investment goods
depends negatively
on the real interest
rate.

I (r )

I
 Government spending, G

• G = govt spending on goods and services.

• G excludes transfer payments
(e.g., social security benefits, unemployment insurance benefits)

• Assume government spending and total taxes are

exogenous:

G =G and T =T
 The market for goods & services
• Aggregate demand: C (Y − T ) + I (r ) + G
• Aggregate supply: Y = F (K , L )
• Equilibrium:

• The real interest rate adjusts

to equate demand with supply.

Y = C (Y − T ) + I (r ) + G
 The loanable funds market
• A simple supply-demand model of the financial
system.

• One asset: “loanable funds”

• demand for funds: investment
• supply of funds: saving
• “price” of funds: real interest rate
 Demand for funds: Investment
The demand for loanable funds…
• comes from investment:
Firms borrow to finance spending on plant & equipment,
new office buildings, etc. Consumers borrow to buy new
houses.
• depends negatively on r,
the “price” of loanable funds (cost of borrowing).
 Loanable funds demand curve
r
The investment
curve is also the
demand curve
for loanable
funds.

I (r )

I
 Supply of funds: Saving
• The supply of loanable funds comes from saving:
• Households use their saving to make bank deposits, purchase
bonds and other assets. These funds become available to firms
to borrow to finance investment spending.
• The government may also contribute to saving
if it does not spend all the tax revenue it receives.
 Types of saving
private saving = (Y – T ) – C
public saving = T – G
national saving, S
= private saving + public saving
= (Y –T ) – C + T – G
National Saving = Y – C – G
 Loanable funds supply curve
r S = Y − C (Y − T ) − G

National saving
does not
depend on r,
so the supply
curve is vertical.

S, I
 Loanable funds market equilibrium

r S = Y − C (Y − T ) − G

Equilibrium real
interest rate

I (r )
Equilibrium level S, I
of investment
 The special role of r

• r adjusts to equilibrate the goods market and the

loanable funds market simultaneously:
• If L.F. market in equilibrium, then
• Y–C–G =I
• Add (C +G ) to both sides to get
• Y = C + I + G (goods market eq’m)
• Thus,

Eq’m in  Eq’m in
L.F. market goods
market
National Savings (Without China)
National Savings (with China)
 Savings and Investment
Things that shift the investment curve
• some technological innovations
• to take advantage of the innovation,
firms must buy new investment goods
• tax laws that affect investment
• investment tax credit
 An increase in investment demand
r S

…raises the • An increase

in desired
interest rate. r2 investment…
r1
But the equilibrium
level of investment I2
cannot increase I1
because the
S, I
supply of loanable
funds is fixed.
 Saving and the interest rate
• Why might saving depend on r ?
• How would the results of an increase in
investment demand be different?
• Would r rise as much?
• Would the equilibrium value of I change?

See the additional reading on Pakistan’s Low saving rate trap.

An increase in investment demand when saving depends on r

r S (r )
An increase in
investment demand
raises r,
which induces an r2
increase in the r1
quantity of saving,
which allows I
to increase. I(r)2
I(r)
I1 I2 S, I
 Change in Saving: Effects of Fiscal Policy

Govt Spending and Crowding Out

• Reagan policies during early 1980s:
1. increases in govt spending: G > 0
2. big tax cuts: T < 0

Both policies reduce national saving:

S = Y − C (Y − T ) − G

G   S T   C   S
 Rise in r and Crowd Out

1. The increase in r S1
S2
the deficit
reduces saving…

r2
2. …which causes
the real interest
r1
rate to rise…
I (r )
3. …which reduces
the level of I2 I1 S, I
investment.
https://www.youtube.com/watch?v=7da2Yy0zXPY
• Modelling an Open Economy in the long-run
The national income identity in an open economy

Y = C + I + G + NX

or, NX = Y – (C + I + G )

domestic
spending
net exports
output
 Role of Net Export
• In closed economy, all outputs are sold domestically.
• Expenditure (Y) = C + I + G

• In an open economy, some output is sold domestically and some is

exported to be sold abroad.
• Expenditure (Y) = (Cd + Id + Gd) + Ex ---- (i)

• Here, (Cd + Id + Gd) is domestic spending on domestic goods and

services and Ex is foreign spending on domestic goods and services
 Role of Net Export…
• C = Cd + Cf
• I = Id + If
• G = Gd + Gf

• Substitute these in equation (i)

• Y = (C - Cf) + (I - If) + (G - Gf) + Ex
• Y = C + I + G + Ex – Em [where, Cf + If + Gf = Em]
• Y = C + I + G + NX
 Role of Net Export…
• NX = Y – (C + I + G)

• Net export = Output – Domestic Spending

• If Output > Domestic spending, net export is positive

• If Output < Domestic spending, net export is negative

 Trade surpluses and deficits
NX = EX – IM = Y – (C + I + G )

• trade surplus:

output > spending and exports > imports

Size of the trade surplus = NX

• trade deficit:

spending > output and imports > exports

Size of the trade deficit = –NX

 Trade surpluses and deficits
Trade Surplus Balanced Trade Trade Deficit

Export > Import Export = Import Export < Import

Net export > 0 Net export = 0 Net export < 0

Y>C+I+G Y=C+I+G Y<C+I+G

Saving > Investment Saving = Investment Saving < Investment

Net Capital Outflow > 0 Net Capital Outflow = 0 Net Capital Outflow < 0
 International capital flows

• Net capital outflow

• = S –I
• = net outflow of “loanable funds”
• = net purchases of foreign assets
the country’s purchases of foreign assets
minus foreign purchases of domestic assets

• When S > I, country is a net lender

• When S < I, country is a net borrower
 The link between trade & cap. flows

• NX = Y – (C + I + G )
• implies
• NX = (Y – C – G ) – I
• = S – I

• TRADE BALANCE = NET CAPITAL OUTFLOW

Thus, a country with a trade deficit (NX < 0)

is a net borrower (S < I ).
Saving and investment in a small open economy

• An open-economy version of the loanable

funds model from Includes many of the same
elements:
• production function Y = Y = F (K , L )

• consumption function
C = C (Y − T )

• investment function I = I (r )
• exogenous policy variables G = G , T =T
 Small Open Economy Model
• Accounting identity, NX = (Y – C - G) – I
• NX = S – I

• Here, NX = (Ȳ– C(Ȳ – T) - G) – I (r*)

• NX = ¯S– I (r*)
 National saving: The supply of loanable funds

r S = Y − C (Y − T ) − G

National saving does

not depend on the
interest rate

S S, I
 Assumptions: Capital flows
• We do not assume that real interest rate equilibrates savings and
investment.
• a. domestic & foreign bonds are perfect substitutes (same risk,
maturity, etc.)
• b. perfect capital mobility:
no restrictions on international trade in assets
• c. economy is small:
cannot affect the world interest rate, denoted r*

a & b imply r = r*
c implies r* is exogenous
 Investment: The demand for loanable funds
Investment is still a downward-sloping function of
r the interest rate,

but the exogenous world interest rate (r*)

determines the investment of a country

r*

I (r )

I (r* ) S, I
If the economy were closed…
r S
…the interest
rate would
adjust to
equate
investment
and saving: rc
I (r )

I (rc ) S, I
=S
But in a small open economy…
r
the exogenous S
world interest
rate determines
investment… NX
r*
…and the
difference rc
between saving
and investment I (r )
determines net
capital outflow I1 S, I
and net exports
 Next, three experiments:
• 1. Fiscal policy at home
• 2. Fiscal policy abroad
• 3. An increase in investment demand
1. Fiscal policy at home
2. Fiscal policy abroad
3. An increase in investment demand
 Numerical
Q. Consider a closed economy operating at full employment capacity
(long run) described by the following equations: Y = C + I + G
• Y = 2000, G = 1000 , T = 800, C = 250 + 0.75 (Y – T)
• I = 1000 – 100 (r) where Y is real GDP, G government expenditure, C
consumption of households, I investment by firms, T net taxes
imposed on households.
• A. Find out private saving, public saving, national saving.
• B. Find the equilibrium interest rate
• C. If G increases to 1,250, find out private saving, public saving,
national saving.
• D. Find out the new equilibrium interest rate.
 Numerical
• Q. Assume GDP is INR 6000, personal disposable income INR 5100,
the government budget deficit INR 200. Consumption is INR 3800
and trade deficit is INR 200. Assuming no transfer, and no net labour
or capital income from abroad, answer the following.

A. What is the saving and Investment?

B. What is the value of Net exports?